SVB, the Fed and a US Recession

Those using crystal balls to predict the future have a high error rate. But in the midst of the banking storm and tempest in the US, let’s make a few predictions.

Will there be a US recession? Yes, if the Federal Reserve is stupid enough to lift its interest rates in the way it had planned a week or so ago. But I think those high interest rate increases have been thrown out of the window in the wake of the Silicon Valley and other small bank crashes. Instead, there will be more moderate increases which will avoid a recession but will still leave inflation at a level the Federal Reserve regards as too high which means that although interest rates won’t skyrocket, to achieve a quick inflationary kill, they will stay at high levels.

In turn that will lower US growth and the period of difficulty will be elongated albeit not as severe as it might otherwise have been. Slower US growth will impact the whole world, led by our biggest trading partner China.

Lowering Rates?

There is also an alternate view that the Federal Reserve (and our Reserve Bank) will start lowering rates. For that to happen, the US banking problems need to reach a crisis point and I don't think that's likely because bank deposits are now being guaranteed and the Silicon Valley Bank (and some of the other failed banks) were incompetent because they had a huge balance of “surplus” deposits which they invested in long-term bonds which slumped in value. Silicon Valley was too small to be properly regulated and it had a poor board and management.

What about Australia? Our central bank is also facing severe community pressures to limit future interest rate rises. Had the US increased its rates substantially then the markets would have put great pressure on Australia to follow with a consequent domestic slump but a faster reduction in inflation. Instead, like the US, we are likely to have a period of higher-than-normal interest rates accompanied by inflation above the Reserve Bank’s target.

And, of course, this is exactly what the bond and share markets are predicting. At the start of the week money poured into US bonds, slashing rates, but the bond market has now stabilised along with the share market — in line with my scenario.

Further big falls in bond yields and the US share market would indicate that investors believe there are serious problems in the US because of bond losses in the banks and those problems may require lower interest rates. That’s not my forecast but watch market trends.

Gunning for Growth

Australia is proposing massive investment in both disabilities and defence in coming years. And we will attempt to borrow some of the money, which will keep rates higher, but we desperately need growth.

That growth can come from the mining sector given the electrification boom which will create strong demand for copper, nickel, lithium and iron ore (steel) although that demand will be moderated by lower world growth.

Part of the Australian problem in realising our growth potential is that the Albanese government is struggling in its domestic decision-making process. It dreamed up the idea that there should be a cap on superannuation balances without contacting the industry funds who would have told them that their systems couldn’t isolate that information. To save face they instituted a draconian tax that levies unrealised gains and abandons the discount for capital gains taxing. This is a very bad precedent which will impact confidence in superannuation.

And just to make matters worse, Treasury slipped a “Mickey Finn” into the Treasurer’s policy drink inducing him to make franking credits far more complex. If the bill passes, then when a company declares a special dividend (not easy to define) and makes a share issue either before, at the same time as the dividend, or after the dividend, the franking entitlement is endangered.

Treasury has always hated franking credits so they designed this tax to make franking credits more complex so that later, when companies are having difficulty with franking credits, they will suggest that the whole thing be abandoned.

Treasury tried the same stunt on Scott Morrison when he was treasurer and he fell for it. When Josh Frydenberg became treasurer, he quickly grasped the treasury game and didn’t introduce the Morrison measure. But Jim Chalmers, like Morrison, was fooled. 

We have to hope that the new environment created out of the US banking system setbacks plus the need for growth and savings given our defence expenditures will cause the Albanese government to wake up. But there are no certainties.

The Allure of Gold

Meanwhile, we face a period where investing will require skill in isolating companies that can do well in this new environment. Many will prefer interest-bearing securities led by the hybrids and other debt type securities issued by banks. 

But in this environment, gold and gold shares may emerge as a favoured place to store money. In this context keep your eye on the Newmont bid for Newcrest (ASX: NCM) which slashes the gold backing of the stock currently held in Newcrest.

Newcrest directors will be torn between trying to satisfy those amongst its shareholders who want a quick dollar from the Newmont bid and those that want longer term rewards via greater gold backing for their money.

The reduction in gold asset backing contained in Newmont’s share exchange bid arises because global share investors place a premium on Newmont shares that is not awarded to the Australian company stock. Newmont regularly uses that higher premium to cheaply acquire its urgently needed gold reserves. Australia’s Newcrest is the latest target.

Property Investment 

With interest rates moderating and building costs high, many will be tempted to invest in an existing residential property.

One of the reasons why rents have risen spectacularly is that governments, particularly those in Victoria and Queensland, have driven investors out of the housing market with anti-landlord rules that make it very dangerous to rent out a property on a long-term basis because a bad tenant can cause huge financial damage. Rather than rectify their bad legislation governments are looking to build social housing.

Almost certainly industry funds will be harpooned into these investments. Those with money invested in these funds should be wary while those tempted to buy a house as an investment need to start with a good long-term tenant or use the Airbnb market.